The Float

Newton's First Law of Retirement Plans

Three recent encounters have reminded us just how powerful inertia can be.

When Newton wrote that "every body perseveres in its state of being at rest or of moving uniformly straight forward, except insofar as it is compelled to change its state by force impressed," he probably didn't have defined-contribution retirement plans in mind. But it's no great leap to take his First Law of Motion and apply it to the world of 401(k), 403(b), and 457 plans.

Encounter One: Prompted by one friend of ours, another friend asks for a little help with her 401(k) allocation. So we take a look, and here's what we find: A very typical menu of roughly 20 mutual funds, split between the biggest, most bloated brand names in the industry and index funds with expense ratios greater than 0.5%. Other plan characteristics: Only one international equity option, no REIT funds, and no commodities vehicle. So the investment options were mediocre at best. And what had our friend done with those options? Her deferrals were split 50-50 between U.S. large-cap stocks and U.S. small-cap stocks. That's it. That was the totality of her "asset allocation."

The good news is that she has saved diligently and accumulated a decent nest egg for someone who's only 34 years old. She should be proud of herself for that. But how much larger would her account be if she had participated in a richer mix of asset classes? How much larger would it be if she'd paid legitimate index-fund prices of 10 to 25 basis points rather than inflated tariffs for mediocre actively-managed funds? Back to Newton: This investor would have simply stayed in motion had we not changed her course "by force impressed." We were happy to do so, but we shudder to think of how many millions of Americans remain saddled with wildly sub-optimal retirement plan options and strategies.

Encounter Two: We recently had lunch with two accomplished ERSIA attorneys, one very senior, the other relatively junior. When we asked the senior attorney about plan sponsors' awareness of their fiduciary duties and risks, he stated in no uncertain terms that they (plan sponsors) have a very limited understanding of the nature and scope of their responsibilities under ERISA and the Pension Protection Act of 2006. Which, in our Newtonian world, is one reason so many thousands of retirement plans remain so poorly constructed. In the absence of a powerful outside force, many plan sponsors demonstrate an equally powerful form of inertia, settling for off-the-shelf, status-quo plans that simply don't live up to legitimate fiduciary standards.

What sort of outside force might shake sponsors out of their complacency? Here's a partial list: Employee revolt (unlikely*), litigation (unlikely in the short term for all but the deepest-pocketed sponsors, but a near-certainty for some plans in the medium or long term), legislation (the PPA is having some effect, but at this point it's more muted than many observers expected), regulation (last week's QDIA decision will help), and genuine fiduciary guidance from trusted advisors (especially attorneys, accountants, and investment professionals, but also fellow business owners and executives who recognize the profound importance of getting retirement plans right--and the very real risks of getting them wrong).

The bottom line is that sponsors need help from people who should know non-fiduciary plan characteristics when they see them. Without that kind of intervention, retirement plan inertia will consign millions of Americans to much poorer long-term outcomes than they could--and should--have enjoyed.

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*Just how unlikely? That leads us to Encounter Three. Last night, we heard this from a plan participant: "Who cares what the fees are!? My employer matches 3 percent!"

Friday Reading

No-news-is-good-news edition...

• From an environment where good news was good for the equity markets (because it reflected economic strength) and bad news was good for the equity markets (because it would compel the Fed to continue cutting rates), investors have made a three-day u-turn. Now, it seems, the news that matters concerns the things we don't know: How ugly is it at Citi? What's Merrill up to with its off-balance-sheet activities? Is the unstoppable U.S. consumer running out of gas? How real were those 166,000 new jobs in October?
• Don't let all the media/blogosphere talk about the equity markets obscure what's happening in the bond pits: A big-time flight to quality.
• This isn't good news (via Andrea Coombes at MarketWatch): "Fifty-three percent of full-time, full-year wage-and-salary workers age 21 to 64 participated in an employer-sponsored plan in 2006, down from 55% in 2005, according to EBRI."
• Market volatility may be stressful for investors, but it's all good for the exchanges that handle the trading traffic.
• Good piece on The Entity (i.e., SIV/MLEC) from Eric Dash in yesterday's New York Times.
• James Picerno updates his asset class numbers through October, noting that the "bull market in everything" continued apace. November isn't off to such a hot start, of course, but Picerno is right about the last several months: "There's been no reward for anything other than embracing risk."

Merrill Stung (and Stings) Again

In today's Wall Street Journal, Susan Pulliam pulls the curtain back on some vague but troubling speculation about Merrill's attempts to hide some of its uglier marks through private deals with hedge fund managers. Here are the opening paragraphs:

Merrill Lynch & Co., in a bid to slash its exposure to risky mortgage-backed securities, has engaged in deals with hedge funds that may have been designed to delay the day of reckoning on losses, people close to the situation said.

The transactions are among the issues likely to be examined by the Securities and Exchange Commission. The SEC is looking into how the Wall Street firm has been valuing, or "marking," its mortgage securities and how it has disclosed its positions to investors, a person familiar with the probe said. Regulators are scrutinizing whether Merrill knew its mortgage-related problem was bigger than what it indicated to investors throughout the summer.

In  one deal, a hedge fund bought $1 billion in commercial paper issued by a Merrill-related entity containing mortgages, a person close to the situation said. In exchange, the hedge fund had the right to sell back the commercial paper to Merrill itself after one year for a guaranteed minimum return, this person said.

While the Merrill-related entity's assets and liabilities weren't on Merrill's own balance sheet, Merrill might have been required to take a write-down if the entity was unable to sell the commercial paper to other investors and suffered losses, the person said. The deal delayed that risk for a year, the person said.

In a statement, a Merrill Lynch spokeswoman said, "We don't comment on specific transactions and we are confident in the appropriateness of our marks."

At issue with any hedge-fund deals is whether there was an attempt by Merrill to sweep problems under the rug through private transactions kept out of view from investors. Some previous scandals, such as the collapse of Enron Corp. and the troubles of Japan's financial system in the 1990s, involved efforts to hide problems through off-balance-sheet transactions.

This is a story worth watching. Though the details are sketchy, the bottom line is that firms like Merrill (as Pulliam points out, Bear Stearns has engaged in similar behavior) can't--and shouldn't!--play shell games with their risk exposures and losses.

Source

Susan Pulliam, "Deals With Hedge Funds May Be Helping Merrill Avoid Mortgage Losses," Wall Street Journal, November 2, 2007

Final QDIA Regulations

As the financial markets continue the kind of whipsaw action that has become increasingly common over the last few months, the Department of Labor's recent announcement of final regulations on the question of Qualified Default Investment Alternatives (QDIAs) should be welcome news to anyone who cares about Americans' retirement security--which, of course, should be everyone.

As we wrote on September 5th, the insurance industry battled to keep stable-value funds (i.e., low-yielding, "guaranteed" investment vehicles) in DOL's QDIA mix. Fortunately, DOL rejected the insurers' cynical claims in favor of a set of QDIAs that will give millions of 401(k) participants a much better chance of decent long-term investment outcomes.

Pursuant to the Pension Protection Act of 2006, here are the key definitions of QDIAs:

• A product with a mix of investments that takes into account the individual's age or retirement date (an example of such a product could be a life-cycle or targeted-retirement-date fund)
• An investment service that allocates contributions among existing plan options to provide an asset mix that takes into account the individual's age or retirement date (an example of such a service could be a professionally-managed account).
• A product with a mix of investments that takes into account the characteristics of the group of employees as a whole, rather than each individual (an example of such a product could be a balanced fund).
• A capital preservation product for only the first 120 days of participation (an option for plan sponsors wishing to simplify administration if workers opt-out of participation before incurring an additional tax).

One other detail: QDIAs cannot include employer securities (i.e., company stock).

For a little more on this story, check out Robert Powell's recent column at MarketWatch.

Source

Robert Powell, "Qualified approval," MarketWatch, October 31, 2007

Parsing the Fed

From the (free) Wall Street Journal...

Fed Out of the Box

As we expected, Bernanke & Co. created a little more wiggle room for themselves in this afternoon's statement. Note the key sources of wiggle room in bold...

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 4-1/2 percent.

Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance.  However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction.  Today's action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.

Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation.  In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth.  The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.

Voting for the FOMC monetary policy action were:  Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Donald L. Kohn; Randall S. Kroszner;
Frederic S. Mishkin; William Poole; Eric S. Rosengren; and Kevin M. Warsh.  Voting against was Thomas M. Hoenig, who preferred no change in the federal funds rate at this meeting.

In a related action, the Board of Governors unanimously approved a 25-basis-point decrease in the discount rate to 5 percent.  In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Richmond, Atlanta, Chicago, St. Louis, and San Francisco.

A Little Perspective on Fed Day

As the Fed's zero hour approaches, we thought we'd try to summarize the state of the financial-economic world with a few simple observations...

• However severe financial markets stresses were in early August, things have since come unstuck and markets are once again functioning reasonably well.
• Functioning markets sometimes send asset prices lower, as is the case with various securities related to the mortgage markets (emphasis on subprime, option ARMs, &c.).
• For all the breathless talk about central banks' "injections of liquidity," it's worth remembering that liquidity is basically a state of mind.
• Housing stinks something fierce. There's no getting around that, and it ain't turning around any time soon.
• The global economy remains very dynamic--and increasingly interdependent.
• Inflation is real--not spiraling out of control, but real. The key question, which has implications for Fed policy-making, is where its effects manifest themselves. In consumer prices? Or in margin compression at the corporate level?
• The American consumer is one of our planet's most astonishing species: resilient, adaptable, downright indefatigable. So far, anyway.
• Bernanke & Co. have surprised market participants before, but, as Alan Blinder said on CNBC this afternoon, the Fed appears boxed in by market expectations. 25 basis points could be nearly automatic this time, but the Board of Governors' statement may well reflect their effort to unbox themselves for future meetings.

Golf as a Contrary Indicator

Just spoke with a friend and former colleague at Merrill Lynch, who filed this pithy report on the firm's departed boss:

"I just returned from a two-month leave of absence. During those two months, I played 12 rounds of golf. Stan O'Neal played 20."

Nero fiddled while Rome burned; O'Neal teed it up.

Wednesday Reading

As the world waits for Bernanke & Co....

• Bloomberg's Vivien Lou Chen sees a "nimble" Fed navigating (certain) robust economic data and continuing concerns about housing and financial-market conditions.
• Robust economic data? Try these Q3 GDP numbers.
• MasterCard blows it out this morning. That's great for its shareholders, but this strikes us as another indication of consumers' ongoing rotation from mortgage equity withdrawal to revolving credit.
• For more on the role of revolving credit, see this bracing report from Fortune's Peter Gumbel.
• And for more on the imperative of credit expansion, see today's missive (and item #4 in particular)from Minyanvile's Kevin DePew.
• At the risk of raining on today's GDP/Fed parade, here's a reminder from Northern Trust's Paul Kasriel and Asha Bangalore that it's not all sweetness and light out there.
• The Case-Shiller Home Price Index shows no signs of turning higher any time soon, but as Calculated Risk points out, home price changes tend to be relatively sticky.
• In the November issue of Wealth Manager, James Picerno riffs on the resurgence/durability of beta in the theory and practice of portfolio management.

401(k) Workshop

We're brutally late posting this afternoon because we spent the day preparing for and conducting a 401(k) workshop for a fascinating group of professionals here in Madison. The point of the event was to help plan sponsors and various trusted advisors better understand (1) the true costs of the typical defined contribution plan, (2) the current legal and regulatory environment, and (3) the core characteristics of a genuinely fiduciary plan.

Based on the questions and comments we received today, it's clear that plan sponsors very much want to do the right thing for their employees...not to mention for their own very legitimate risk management purposes. Sponsors are interested in fiduciary concepts, recent legislative and regulatory changes, and developments in the financial services industry that are opening up impressive new options for defined-constribution plans. The point: The retirement plan marketplace is poised for significant change, and we don't think that change can come fast enough.

As we've written repeatedly in this space, the typical 401(k) plan, in which participants are presented with a menu of mutual funds and encouraged to do their best, is a badly broken model that screams out for fundamental reform.

That reform incorporates lots of details, but the central objective is incredibly simple: Deliver plans that give participants the highest possible likelihood of capturing long-term returns that are as close to the efficient frontier as possible (see adjacent chart from Investopedia, with apologies for the inappropriate apostrophe in "portfolios"; see also this July comment from Mercer Bullard to the DOL for a similar argument). What sort of plan would actually locate participants' long-term outcomes near the line indicating optimal returns for given levels of risk?

We think fiduciary plans--plans that live up to the principle and promise of ERISA itself--will feature relatively few investment choices, all of which are fully diversified, pension-caliber portfolios incorporating multiple asset classes through the use of inexpensive index-based vehicles.

ERISA, the Pension Protection Act of 2006, and Department of Labor rulemaking provide both general encouragement and specific safe harbor provisions designed to push plan sponsors into a more paternalistic stance relative to their employee-participants.

By adopting plans with true fiduciary characteristics, sponsors can simplify lots of lives (their own and those of their employees), save lots of money (after all, sponsors are participants too), and, most importantly, improve participants' long-term investment outcomes--and thus not only their standards of living in retirement, but in some cases their ability to retire in the first place.

The stakes here are very high. And the path forward is plenty clear to anyone who cares to dig underneath the veneer--and false security--of the status quo.